CHINA TIMES: IMCI FUTURES TO BE SHOCK ABSORBER, CASH DELIVERY TO REDUCE SHORT SQUEEZE

Updated on Jun 21,2014

June 21, 2014

By Ye Qing

As the first commodity index futures in China, the IMCI (Industrial Metal Commodity Index) futures to be introduced by the SHFE denotes the dawn of the era of commodity index investment.

As it is reported, the SHFE has compiled the IMCI futures by selecting 4 products: copper, aluminum, zinc, and lead as the component commodities, and it has, starting from May 19, unveiled simulation trading of the IMCI futures. For one month since startup of the simulation trading of the IMCI futures, the trading has been going on steadfastly and orderly, and the technical system has been running well.

Up to June 18, there records a total trading of 9.317 million contracts in the simulation trading, witnessing a total contract value of RMB 256.03 billion, and involving total 1,612 corporate and natural person simulation accounts. Official launch of the simulation trading also marks the SHFE’s onset of an era of commodity futures derivatives, and it will make available new tools for financial institutions and small and medium-sized nonferrous enterprises to participate in the hedging.

Commodity indexation looks a battle line

In recent days, the SHFE released the “Concentrated Reply to Opinions and Suggestions at the 2014 Regional Members Symposium” via its member service system, and it expressed that, the SHFE would actively explore commodity futures derivatives services, actively push forward the preparatory efforts for listing of the IMCI futures, and in the meantime support the financial institutions’ innovative efforts targeting at nonferrous index products.

Regarding this, Yan Yonghui, Futures Analyst with Nanhua Futures holds that, compared with commodity futures, there are many innovations in the design of nonferrous index futures. For example, the nonferrous index futures cancels the gradient margin in the final delivery month, position threshold margin mark-up, and its emergence would appeal even more institutional investors and industry funds to participate in the market in an effective and reasonable manner, so as to fuel the development of the futures market.

“Commodity index futures will facilitate financial institutions to further partake in the commodity market, while participation by financial institutions would better the futures market’s investor structure and effectively enhance liquidity of the commodity market. Commodity index futures enables portfolio arbitrage by arbitrage investment strategy, i.e., index and commodity futures. Moreover, because of the two-way transaction as hallmarked by the futures market, commodity index futures enable short arbitrage as well as long arbitrage.” Sun Liying, international futures analyst notes, when interviewed by the “China Times”, the influx of arbitrage would further increase to liquidity of the futures market.

Futures insiders also consider that, judged from investment means of international commodity index, commodity index investments include mainly commodity index futures and option, commodity index fund, commodity index swap, commodity index ETF. Through interviews and investigations, the journalist informs himself of that, some fund company has planned to launch ETF products tracking the IMCI futures, which, in contrast to investing directly nonferrous metal futures, the nonferrous metal ETF would provide scattered investments of 4 nonferrous futures products at the minimum cost, and provide a path for investors to participate in the development of the nonferrous metal market.

As for corporate investors, commodity index product can be effective in evading the market’s non-systemic risks. Being principally multi-product or multi-contract, commodity index is helpful to avoid short squeeze and market manipulation. Besides, Sun Liying said, the choice of cash delivery also provides convenience for special corporate entities such as banks and funds to take part in the commodity market, and facilitates financial institution to further participate in the commodity market. Currently, there exist some systematical barriers for institutional investors as funds, securities institutions, to participate in the commodity futures market, for example, the inability to draw VAR invoice. Through investing in commodity index futures, institutional investors can realize the purpose of participating in the commodity market by avoiding those obstacles.

Cash delivery reduces the odds of short squeeze

As it is reported, the IMCI futures involves 4 futures contracts: cooper, aluminum, zinc, and lead. In the simulation transaction this time, total 5 contracts are listed, respectively the IM1406 (Current Month), IM1407 (Following Month), IM1408 (Third Month), IM1409 (First Quarter), and IM1412 (Second Quarter). The trading hours are 9:00 ~ 11:30 (morning session) and 13:30 ~ 15:15 (afternoon session). However, night session trading is temporarily not opened during the simulation trading period.

The launch of the simulation trading has drawn widespread attention from the market, and it has allured a large number of investors. Mr. Wang Fuxuan, Assistant Director of Jinrui Futures Research Institute, said, the real spotlight of the simulation trading this time lies in its cash delivery, which distinguishes itself the most from other commodity futures. Comparing with traditional physical delivery, cash delivery facilitates greatly small and medium-sized investors to control their risks, as well as institutional investors to participate in the commodity futures market, well suiting to needs of the market participants. Thus, both clients and investors have great enthusiasm.

“As a matter of fact, cash delivery is not only the best way for enlivening contracts of current month, but also a measure for curbing excessive speculation. In a market devoid of cash delivery, speculators may well suppose a picture ‘Limited Commodities but Unlimited Currency’. However, cash delivery can be a break to this pattern. This is to say, the adoption of cash delivery would mean unlimited commodities, and this can reduce the probability of short squeeze.” said Wang Yong, General Manager of the Strategy Department of Nanhua Futures, when he was interviewed by the “China Times”.

For instance, as soon as the notification for launching the Methanol Futures Mini Contract 1506 is given, the price goes up amid sizzling speculation. That is actually indicative of the speculation: “Limited Commodities but Unlimited Currency”. The circumstance of this year occurred not only in the methanol product, and the same circumstance of “short squeeze” also occurred in the plastic and blockboard futures. Especially for the plastic futures, it is really beyond understanding as the price goes up so high in the off-season of farm-use plastic film.

As Wang Yong puts it, the abnormity in plastic futures price would cue wrongly to manufacturers of the industry to beef up the production and investment, resulting in poor sales as well as in inventory-caused cash flow occupation, which in turn deteriorates the balance sheet. If let go of it, up to 50,000 to 60,000 small enterprises in the downstream of the industry will suffer great losses. Besides, cash delivery would draw a bunch of enterprises not up to the hurdle line for physical delivery for hedging.

Take methanol product as example, the methanol delivery commodity shall be the imported, while methanol produced in China is largely made from coal. It is a product of low-carbon, green and cyclic economy, but it is not qualified for delivery. The same is true for plastic product, as the delivery commodity shall be made from petroleum. Nevertheless, China’s plastics products, with 60% made from coal, which is the result of the cyclic economy. Thus, these products can not be directly delivered.

Despite the Dalian Futures Exchange’s recent change to the delivery rules, since the introduction of plastic futures contract 1506, coal-based plastic is qualified for delivery. However, in case cash delivery is implemented, there would be a large number of coal enterprises to trade. Apart from it, there shall be reforms in the tax system, and commodity transactions should be exempted from taxes. As it is the practice in European and American countries, individuals will be subject to taxes for engaging in commodity futures trading, while enterprises will be exempted from taxes, and this is a fundamental measure for containing speculation.

It is known that European and American futures markets are characterized by its magnitude of institutional and corporate investors, and this is largely decided by their tax systems. In contrast, individual investors make up the majority in China’s futures market, which is also decided by China’s taxation system. Enterprises in China are required to pay taxes, while individuals are exempted from them. As a result, a host of corporate investors open their trading accounts in the name of individual investor. As individuals are not qualified for delivery, corporate investors have to make speculation. Thus, implementing cash delivery can contain individuals’ speculation.

Give play to “Shock Absorber” effect of the market

According to someone of the SHFE, the purpose of simulation trading is to provide investors with a platform for commodity index futures trading, through which investors can acquaint themselves with trading rules and get correct understanding of the commodity index futures market.

“Before launch of the commodity index futures, it is hard for manufacturing enterprises, especially the enterprises characterized by continuous manufacturing or planned sales according to capacity, to carry out hedging with a uniform hedging instrument. For example, for an enterprise needing continuous production, what it really needs is to hedge its cash flow, but existing hedging instruments are not perfect. Consequently, we are very much reluctant to take part in the futures market”, told by Manager Li of a copper producer in Shandong Province, “If the index futures is available, that would be much a desire.”

As a matter of fact, it is learnt in the futures industry that the listing of nonferrous index futures, solely from market indications, can better showcase the development and change of the nonferrous metals industry as a whole. In the high-level fitting process with the spot market, the nonferrous index futures can also play as the “Shock Absorber” of the market, to enhance stable performance of targeted products of nonferrous metals futures.

“The index futures can not only provide a new instrument for small and medium-sized nonferrous firms to hedge, but also help strengthen the functions as price finding and risk management in the futures market. In addition, the design of index futures contracts should not preferably cover all the months, while they shall be established for dominant contracts only. Thus, probability of index manipulation will be lowered”, told Wang Yong.

Wang Yong held that on the contract design, only one index in one quarter is preferable for the dominant contracts, and for particular futures products, even one index for half a year. Only such an index is established, can institutional investors and enterprises be attracted, especially those firms characterized by continuous production, and of course, also those firms deciding sales according to capacity. Also, an index contract should be of broad fundamentals, and number of relevant contracts should be minimized; a narrow-fundamental index will then be established after the broad-fundamental index is under smooth operation, so as to shape a common index before hedging funds could be allured.

Qu Xiaoning, Deputy General Manager of the Market Development Department of Minsheng Futures, held that the IMCI futures currently takes price data of the futures products of copper, aluminum, zinc, and lead in the futures market as the fundamental data, the indexed product, unlike common commodity futures, does not reflect characters of a single future product but the common characters of the whole industry. The introduction of the IMCI futures enriches means of hedging for industry clients. Combined with single futures product, the IMCI futures can realize precise risk evasion and further fuel the development of industry risk avoidance funds.